Feature

Big Deal for a Baby Berkshire

Leucadia is paying less than book value for Jefferies. That may upset some Jefferies holders, but there's some consolation because Leucadia trades below its book value. With the addition of Jefferies, Leucadia's earnings power should rise, boosting book value. That could lead to an appreciable rise in Leucadia's depressed share price.

The deal offers benefits to both. For Leucadia (ticker: LUK), it solves a leadership-succession issue because the CEO of Jefferies (JEF), Richard Handler, 51, is slated to head Leucadia after the closing of the deal expected in next year's first quarter. The current duo that have led Leucadia since the 1970s, Joe Steinberg and Ian Cumming, are 68 and 71, respectively.

Leucadia also benefits because it's buying a nicely profitable firm and thus should be better able to make use of $1.4 billion of deferred tax assets that might otherwise have to be written off. Leucadia's current businesses don't generate a lot of profits, netting about $100 million in the first nine months of 2012. Management is more interested in increasing book value than in reported profits.

Leucadia plans to swap 0.81 of its shares for each Jefferies share. Last week Jefferies rose 10% to $15.75, while Leucadia declined 6% to $20.48. Leucadia plans to spin off its California wine business, with a book value of $197 million, or 81 cents a share, to its holders before the deal closes. Adjusting for the wine spinoff, Jefferies trades about 20 cents below the value of the Leucadia offer.

"The deal gives Jefferies access to a strong liquid balance sheet outside its own, and it clearly resolves some of the management uncertainty at Leucadia," says Keith Trauner, the co-manager of the GoodHaven Fund. "I have a lot of respect for the management of both companies. They are sharp businesspeople who have created risk-averse cultures and have proved they can make money." GoodHaven is a Jefferies holder.

While Leucadia didn't offer a big premium, its shares now trade below the projected postmerger book value of $24.69. Handler said on a conference call that "Leucadia has a very reasonable valuation," adding that the combination would build long-term value for shareholders. Handler owns about $235 million of Jefferies stock.

Leucadia is paying less than book value for Jefferies, which looks like an attractive purchase price, given that Jefferies historically has earned high returns and traded above book. That may not sit well with some Jefferies holders. The stock is at half its peak price in 2006.

The combined companies will have $9.3 billion in book value. Leucadia has a liquid balance sheet with cash and public securities of $2.4 billion, offset by $960 million of debt. Handler didn't offer much guidance about how the two companies will operate once they are together but Leucadia presumably will continue to make investments and buy businesses.

Neither company has a great credit rating, with Jefferies carrying a low investment-grade rating of triple-B from Standard & Poor's, and Leucadia carrying a junk-grade rating of double-B-plus. S&P said it expects to upgrade Leucadia's credit rating after the deal.

LEUCADIA RESEMBLES THE BERKSHIRE of 20 years ago before Berkshire (BRK.A) bought a lot of lucrative businesses. Leucadia owns a grab bag, led by National Beef Packing, a meatpacker for which Leucadia paid $868 million for a 79% stake last year. It also owns the Hard Rock Hotel & Casino in Biloxi, Miss.; plastics and lumber businesses; and a company developing a blood substitute.

Cumming and Steinberg keep a very low profile and ignore Wall Street, resulting in virtually no analyst coverage. Aside from their candid annual shareholder letter and their appearance at the annual meeting, they rarely say anything publicly. No conference calls. No investor days. The recent earning release had one substantive sentence, plus a financial table. They also seem obsessed about minimizing taxes. "We will stay focused on creating wealth over the long term while the pundits on Wall Street continue to squawk over quarterly earnings, P/E multiples, and investor calls," they wrote in the latest annual letter.

Warren Buffett is a fan of the company, having partnered with Leucadia in forming Berkadia, a commercial-mortgage servicer and originator.

The Bottom Line

With the addition of Jefferies, Leucadia's earnings power should rise, boosting book value. That could lead to an appreciable rise in Leucadia's depressed share price.

Like Buffett, Steinberg and Cumming focus on growing book value, and they have a strong record. The stock has risen at a 19.8% annual rate from 1979 through 2011, versus a 10.9% rate for the S&P 500. The stock is down sharply, however, from its 2007 peak of $56, as the price/book multiple has collapsed. Leucadia's biggest recent score was a 2006 investment of almost $450 million in Fortescue Metals, an Australian iron-ore producer. Leucadia finished selling its Fortescue stake in September and netted a profit of more than $2 billion.

Leucadia and Jefferies are well known to each other. Leucadia owned 28% of the firm prior to the merger deal and held about half of one of Jefferies' best businesses, its junk-bond trading desk. It's rare for a Street firm to take a partner for a trading operation.

With an expanded capital base and an enhanced earnings base, Leucadia could experience better growth in its book value in the coming years, providing attractive returns to investors.